This Document Contains Chapters 3 to 4 Chapter 3: Supply and Demand What’s New in the Fifth Edition? • Enhanced in-class activities and handouts Chapter Objectives • Introduce the key features of a competitive market. • Define the demand and supply curves. • Explain the difference between movements along a curve and shifts of a curve. • Demonstrate how the supply and demand curves determine the equilibrium price and quantity. • Explain how the market moves back to equilibrium in the case of a surplus or a shortage. Teaching Tips Supply and Demand: A Model of a Competitive Market Creating Student Interest • Ask students if they can think of anyone who would like to be able to predict when the price of something is going to go up or down. Buyers, sellers, and speculators can benefit from this information (buy low, sell high!). Ask them if they can think of anyone who would like to be able to predict when quantities demanded will increase or decrease. Sellers especially need to plan for these changes (e.g., hiring more workers or laying them off). Explain that they are about to learn a model that will help them to predict the effect of changes in the economy on prices and quantities. The information can be very valuable (making money in the stock market, for instance). In fact, it is at the core of what many people do for a living—predicting changes in markets. Presenting the Material • After defining a competitive market, have students try to think of goods or services that fit the definition of a competitive market, such that there are many buyers and sellers of the same good or service. Students will have fun trying to think of a good or service that is the same between all firms. Some reasonable examples are agricultural commodities (such as apples or lettuce), sugar, flour, white printer paper, or natural gas. Ask the students if there are many buyers and sellers of the same good or service and no individual buyer or seller can influence the price, and if all sellers are selling an identical good in the markets they suggest. If the answer is no, then it is not competitive. Use this chance to make sure they understand that most markets do not fit this definition. The Demand Curve Creating Student Interest • Pair up students and ask: What did you buy recently, and why? Then ask a few pairs to report. List on the board the various factors that influenced their decisions. These will range from “it was convenient” to “I wanted it.” Often, students will say they “needed” to buy something. However, if you ask them if they had a substitute, they will understand that they preferred the item. From the list on the board, it is clear that price is just one of many factors that can influence demand. Indicate that we will focus on price first and how it influences the amount consumers want to buy. Presenting the Material • Help students understand the idea that points on the demand curve represent how much a person is willing to pay for a good or service. (Handout 3-1 provides students a place to record this information and answer questions on their own.) Consider the market for movie tickets. Ask for three volunteers. Ask each student “At a price of $10 per movie ticket, how many tickets would you buy in a month?” Allow them to believe that there are an ample number of movies they will want to see in the theater and that they should include tickets for friends to go with them, if they want to buy those. Continue questioning the same three students for each price level in the chart below. At the end of the exercise, show them how the number of tickets “purchased” increases as the price goes down. Ask the students who volunteered what other things they considered when they decided how many tickets they would buy (time, income, other things they could do with their time and income). Then, complete the exercise by showing how a market demand curve can be constructed by adding up the number of tickets at each price level. Draw the demand curves on a graph and show the horizontal sum of the individual demands to make the market demand. Price (per ticket) Quantity (tickets) demanded per month Quantity (tickets) demanded per month Quantity (tickets) demanded per month Total market demand schedule Student 1 Student 2 Student 3 $10 8 6 4 2 0 The Supply Curve Creating Student Interest • Have students imagine they have all been given a free pair of tickets to an upcoming college football game. Suppose it is an important game and all tickets have been sold. Given there are still people who would like to go to the game who do not have a ticket, how many students would be willing to sell their ticket at various prices? Pick some prices and survey your students—results will surely show that as the ticket price rises, more students are willing to sell their tickets. Presenting the Material • Ask students to write down how many hours they are willing to tutor economics students at the following hourly wage rates: $16, $12, $10, $8, $6. Then ask three students to report their responses. Add up the hours at each wage and derive the upward-sloping supply curve. Note: A few students may choose to work fewer hours as the wage rises, but generally the overall response produces an upward-sloping supply curve. • The tutor example helps students see the relationship between individual supply and market supply, and highlights the idea that the supply curve is identifying people’s willingness to sell. Move now to an example of a firm producing a good or service, such as a textbook, or a coffee shop serving customers. Introduce the idea that the firm is willing to sell a good or service as long as the price is at least as high as the marginal cost of producing the good. Students will understand this idea even though they have not been introduced to cost concepts yet. From here you can ask what would cause the firm to want to supply more or less at any given price, or to charge a higher or lower price to sell the same quantity. Be sure to identify the difference between a shift and a movement. Students generally struggle more with supply than they do with demand, especially the idea that a decrease in supply moves the curve up and to the left. Carefully review the factors that shift the supply curve, using lots of graphs and examples. Supply, Demand, and Equilibrium Creating Student Interest • Use the concept of incentives to introduce the idea of equilibrium. Firms have an incentive to charge the highest price possible, but at the same time, buyers have an incentive to search out the lowest price for the good. In a competitive market with many buyers and sellers, this will lead to one equilibrium price for the good. Presenting the Material • Draw a graph showing supply and demand (together at last on the same graph!). Make the point that it is quantity demanded that equals quantity supplied (i.e., supply does not equal demand). Remind students of the distinction made earlier between demand/quantity demanded and supply/quantity supplied. Quantity demanded/supplied refers to the points on the curve (which are equal at equilibrium). Demand and supply refer to the entire curves, which are not equal (they are equal only at the one point). Use this to reinforce the distinctions made earlier. • Remind students that at equilibrium there is balance and there is no tendency for change. Select a price above equilibrium. Ask students what consumers think about a high price. Show the quantity demanded on the graph. Ask them what producers think about the higher price. Show the quantity supplied. Determine the surplus on the graph and ask students what producers will do when surpluses start building up in the warehouse. (They will lower price—i.e., have a sale.) Prices will tend to fall when they are above equilibrium. Ask them how long they will continue lowering price (until the surplus is gone)—that’s at equilibrium! Follow the same process to show the shortage when price is below equilibrium. Ask how producers decide who gets to buy when there is a shortage. (Whoever pays more.) Thus, price will have a tendency to rise when it is below equilibrium, until the shortage is gone—at equilibrium. Only at equilibrium is there no tendency for price to change. There is balance between quantity supplied and quantity demanded. • Give a specific numerical example of an equilibrium price in the natural gas market. Price (per BTU) Quantity (cubic feet) demanded Quantity (cubic feet) supplied $5.00 120,000 200,000 Surplus QS > QD $4.00 160,000 160,000 Equilibrium QD = QS $3.00 180,000 120,000 Shortage QD > QS $2.00 220,000 100,000 Shortage QD > QS Changes in Supply and Demand Creating Student Interest • Ask students to identify some products with prices that have changed recently. Ask them to speculate on what demand or supply factors might have been responsible for the change in the equilibrium price. Presenting the Material • Use the natural gas market presented in the chapter to discuss changes in equilibrium. The table below can be used to represent supply before and after the widespread use of hydraulic fracturing technology. Draw an initial supply/demand graph and identify equilibrium, and then illustrate the shift in supply and new equilibrium. As a second example, consider what happens when there is an increase in demand, say as a result of income rising in the economy. Illustrate the effect on equilibrium price and quantity. Finally, consider the two changes together. Carefully review the idea that when two changes occur at the same time, there will always be an ambiguous result. When two changes occur at the same time, it can be helpful to first analyze the two changes separately and then note that the two changes (either price or quantity) are pushing one of the variables in opposite directions. Therefore, you cannot tell where the variable will end up unless you have specific numerical data. Draw some graphs to show that the simultaneous advance in technology and increase in income can lead to either an increase, decrease, or no change in the price of the good. Two other changes that might occur in this market are an increase in the price of heating oil (a substitute) and an unusually cold winter. Price (per BTU) Quantity before the new technology Quantity after the new technology $5.00 100,000 200,000 4.00 80,000 160,000 3.00 60,000 120,000 2.00 40,000 80,000 • Have students think about a three-step process when they use the supply and demand model. For example, suppose more people prefer to drink coffee. Step one will ask, “Which side of the market is affected: supply or demand?” Step two will ask, “Is it an increase or a decrease in supply or demand?” Step three will shift the curve to the right or left and show the effect on equilibrium price and quantity. • Have students avoid overanalyzing a problem. The common mistake is to say an increase in demand will shift the demand curve to the right. Since this will push the price up, fewer people will want to buy the good at the higher price and demand will shift back to the left. Students in this case are confusing a shift with a movement. A shift of one curve is caused by a change in a variable besides price. This causes a movement along the other curve. Students need to see and practice many examples until this become clear. Common Student Pitfalls • Demand versus quantity demanded. Students often confuse a change in quantity demanded (a movement to a new point on the same demand curve) with a change in demand (the whole demand curve shifts). The difficulty can be caused by either semantics or a misunderstanding of the model. Be sure to explain both the difference in terminology and the difference that applies to the model. Quantity refers to a point and demand refers to the whole curve. Emphasize that quantity demanded refers to the point on the curve and a change in quantity demanded is caused by a change in price. (Point out that price is the variable on the vertical axis.) For each demand curve, price can change but everything else is held constant. A change in any of the things held constant (the determinants of demand: price of related goods, income, tastes, expectations, the number of consumers) will cause the whole curve to shift. This means that, at each and every price, quantity is different. • Supply versus quantity supplied. The same confusion can happen with differentiating quantity supplied and supply. This creates an opportunity to go over the issue again using supply, and the reinforcement can help students get the point nailed down. Students often confuse a change in quantity supplied (a movement to a new point on the same supply curve) with a change in supply (the whole supply curve shifts). The difficulty can be caused by either semantics or a misunderstanding of the model. Make sure that you explain both the difference in terminology and the difference that applies to the model. Quantity refers to a point and supply refers to the whole curve. Emphasize that quantity supplied refers to the point on the curve and a change in quantity supplied is caused by a change in price. (Point out that price is the variable on the vertical axis.) For each supply curve, price can change but everything else is held constant. If any of the things held constant changes (the determinants of supply: input prices, the price of related goods, technology, expectations, the number of producers) the whole curve will shift. This means that, at each and every price, quantity is different. • Equilibrium. Students will often “learn” that equilibrium is where the two lines cross. Reinforce the general concept of equilibrium before discussing the equilibrium in the supply and demand model. Help them to understand that a market continuously informs buyers and sellers where the equilibrium price is so that both adjust their bid and ask prices. This price “clears” the market in that all unsold products must be reduced in price to sell. In a specific real estate market, the market may be moving toward an equilibrium price, as stubborn sellers are forced to lower their prices if they wish to sell now. • Bought and sold. When we start to discuss the equilibrium price and quantity, students will often ask if it is the price or quantity bought or sold. Emphasize that at equilibrium, quantity demanded equals quantity supplied and the price paid equals the price received, so it is both. But also note that in the real world, there can be a difference between the price sellers receive and the price buyers pay (e.g., when there is an intermediary in the market who “takes a cut.” However, at this point, we sacrifice realism in the interests of simplicity and let the equilibrium price and quantity be the same for buyers and sellers. • Which curve is it anyway? Any change in price of a good is likely to have been caused by a change in supply or demand. But students can be confused about which curve it was. It can help them to consider which way quantity changed to be a clue. If price and quantity change in the same direction (say, they both increase), this suggests a shift in demand. If they move in different directions, it suggests a shift in supply. Illustrate these ideas by drawing supply and demand graphs or by having students draw them. Chapter Outline Opening Example: This example discusses the market for natural gas in the United States. Hydraulic fracturing technology has led to a dramatic increase in the supply of natural gas, resulting in a lower price for natural gas. Cheaper natural gas has been beneficial for consumers and firms in terms of lower energy costs. This example will be used throughout the chapter. I. Supply and Demand: A Model of a Competitive Market A. The model of supply and demand has six key elements: the demand curve, the supply curve, the factors that cause the demand curve to shift, the factors that cause the supply curve to shift, the market equilibrium, and the way the equilibrium changes when supply or demand changes. II. The Demand Curve A. The demand schedule and demand curve are illustrated in text Figure 3-1, shown below. B. Demand curves almost always slope downward, as suggested by the law of demand. C. An increase in demand is a rightward shift of the demand curve. 1. When consumers demand a larger quantity of a good or service at any given price, demand increases. D. The difference between a shift of the demand curve and movement along the demand curve is illustrated below in text Figure 3-3. E. Factors that shift the demand curve. 1. Changes in the prices of related goods a. If the goods are substitutes, a rise in the price of one of the goods leads to an increase in the demand for the other good. b. If the goods are complements, a rise in the price of one of the goods leads to a decrease in demand for the other good. 2. Changes in income a. An increase in income increases the demand for a normal good and decreases the demand for an inferior good. 3. Changes in tastes 4. Changes in expectations a. If the price of a good is expected to rise in the future, this will increase the current demand for the good. b. If a person expects their income to rise in the near future, this will increase the current demand for some goods. 5. Changes in the number of consumers a. The market demand curve is the horizontal sum of the individual demand curves, therefore if the number of consumers increases, the market demand curve will increase. III. The Supply Curve A. The supply schedule and supply curve are illustrated in text Figure 3-6, shown next. B. The supply curve is usually upward sloping. The higher the price, the more people are willing to sell. C. An increase in supply is a rightward shift of the supply curve. 1. When people supply a larger quantity of a good or service at any given price, supply increases. 2. If the price of the good changes, there is a movement along the supply curve. D. The difference between a shift in the supply curve and movement along the curve is illustrated in text Figure 3-8, shown next. E. Factors that shift the supply curve. 1. Changes in input prices a. An increase in the price of an input will decrease supply. 2. Changes in the price of related goods or services a. Two goods are substitutes in production when the producer can produce either good with its resources, such as heating oil and gas, or small cars and large cars. b. Two goods are complements in production when production of one good naturally gives rise to production of another good, such as natural gas and oil from a well, or beef and leather. 3. Changes in technology 4. Changes in expectations a. A change in the expected future price can lead a producer to supply more or less today. 5. Changes in the number of producers a. The market supply curve is the horizontal sum of the individual supply curves. IV. Supply, Demand, and Equilibrium A. A market equilibrium defines both the equilibrium price and the equilibrium quantity. Market equilibrium is illustrated in text Figure 3-11, as shown next. B. Why do all sales and purchases in a market take place at the same price? In any market where buyers and sellers are around for some time, they will observe which price works best for them. If a seller is trying to charge above the equilibrium price, buyers will shop elsewhere. C. Why does the market price fall if it is above the equilibrium price? The quantity supplied in the market is greater than the quantity demanded. Excess supply causes the market price to fall. D. Why does the market price rise if it is below the equilibrium price? The quantity supplied is less than the quantity demanded, and there will be excess demand, causing the price to rise. V. Changes in Supply and Demand A. What happens when the demand curve shifts? 1. An increase in demand (the demand curve shifts right) leads to a rise in both the equilibrium price and the equilibrium quantity. 2. A decrease in demand (the demand curve shifts left) leads to a fall in both the equilibrium price and equilibrium quantity. B. What happens when the supply curve shifts? 1. An increase in supply (the supply curve shifts right) leads to a fall in the equilibrium price and a rise in the equilibrium quantity. 2. A decrease in supply (the supply curve shifts left) leads to a rise in the equilibrium price and a fall in the equilibrium quantity. C. Simultaneous shifts in supply and demand. 1. The results for equilibrium quantity and equilibrium price depend on the direction of the shifts in supply and demand, and by how much these curves shift. Case Studies in the Text Economics in Action Beating the Traffic—This EIA uses an auto trip to the center city as a “good” to explain how cities attempt to address traffic congestion. Examples include decreasing the price of substitutes (subsidizing mass transit), increasing the price of complements (increasing the costs for parking and taxes), and increasing the price of driving by means of the adoption of a “congestion charge.” Ask students the following questions: 1. How can a city reduce the demand for traffic by lowering the price of a substitute? (Cities reduce the price of subway and bus rides.) 2. How can a city reduce the demand for traffic by raising the price of a complementary good? (Cities raise the price to park in a garage.) 3. As a result, show graphically what happens to the demand for the highway. (The demand curve for traffic shifts to the left.) Only Creatures Small and Pampered—This EIA uses supply and demand to explain why the quantity of large animal (farm) vets has decreased while the quantity of small animal (pet) vets has increased. The number of pets, the income of pet owners, and competition are used to explain the changes. Ask students the following questions: 1. What has happened to the number of pet veterinarians over the past two decades and why? (It has increased because the service has become more lucrative as the number of pet owners and their incomes have increased.) 2. How has the number of pet vets affected the supply of farm veterinarians? (The number of farm vets has decreased, because pet vets and farm vets are services related in production—vets can specialize in one field or the other.) 3. Use a graph to show the effect of the changes over the past two decades on the market for pet vet services and the market for farm vet services. (Demand increases in the pet vet services market—increasing quantity supplied—and supply decreases in the farm vet services market.) The Price of Admission—This EIA looks at the markets for concert tickets and explains why different markets have different equilibrium prices for the tickets. Tastes and opportunity costs help to explain the differences. Ask students the following questions: 1. Why are there different prices for concert tickets depending on where you buy them? (Tastes and opportunity costs.) 2. Do internet concert ticket markets appear to be competitive? How do you know? (Yes, prices tend to move to an equilibrium.) The Cotton Panic and Crash of 2011—This EIA explains the cause of the sharp rise and the sharp fall in cotton prices in 2011. Ask students the following questions: 1. What were the demand-related factors that contributed to the increase in the price of cotton? (There was a greater demand for cotton clothing from countries like China with growing middle classes.) 2. What were the supply-related factors that contributed to the increase in the price of cotton? (Flooding in some cotton-producing countries and restrictions on cotton exports by India.) 3. What caused the sharp decrease in cotton prices by the end of 2011? (Clothing manufacturers switched to cheaper fabrics and farmers planted more cotton.) Global Comparison Pay More, Pump Less—The law of demand is illustrated using differences in gasoline prices between countries. As gas prices increase in a country (in part, due to taxes), gasoline consumption decreases. Business Case An Uber Gives Riders a Lesson in Supply and Demand—This business case discusses the rise of Uber—a service that connects people who need a ride with those who have a car. Web Resources Useful examples for teaching supply and demand can be found on this website: Internet Center for Management and Business administration, Inc. hhttp://www.netmba.com/econ/micro/supply-demand/ A number of potentially interesting supply and demand games can be found online. Here are two possibilities: http://www.shmoop.com/supply-demand/game.html# http://www.econport.org/content/teaching/modules/DemandSupply.html Handout 3-1 Date_________ Name____________________________ Class________ Professor________________ Consider the market for movie tickets. Ask three classmates “At a price of $10 per movie ticket, how many tickets would you buy in a month?” Allow them to believe that there are an ample number of movies they will want to see in the theater and that they should include tickets for friends to go with them, if they want to buy those. Continue questioning the same three students for each price level in the chart below. Price (per ticket) Quantity (tickets) demanded per month Quantity (tickets) demanded per month Quantity (tickets) demanded per month Total market demand schedule Name of Student 1 Name of Student 2 Name of Student 3 $10 8 6 4 2 0 Ask the classmates what other things they considered when deciding how many tickets they would buy. Record their answers here. Add the quantities of tickets each classmate will buy at each price level (i.e., add the numbers across the rows). Record this sum in the last column. What happens to the number of tickets each student will buy as the price falls? Draw the market demand curve on the graph below. Be sure to label the axes. Handout 3-2 Date_________ Name____________________________ Class________ Professor________________ Shifts and Movements Along the Demand Curve Decide whether the following examples indicate a shift of the demand curve or a movement along the demand curve. Mark the correct column. Example Movement along the demand curve A shift in the demand curve 1. Mammoth Mountain hikes the price for ski tickets and sales plummet. 2. Lack of snow keeps the skiers away. 3. An increase in the excise tax on cigarettes causes younger smokers to quit. 4. Cutting cigarette ads from TV causes cigarette smoking among teens to fall. 5. Nike sales fall as Skechers shoes gain popularity. 6. Teens have had it with the high price of Nike Air Jordans. 7. Mortgage rates are at an all-time low, and new home loan applications soar. 8. A booming economy spurs home sales. Handout 3-3 Date_________ Name____________________________ Class________ Professor________________ Consider the market for movie tickets. Ask three classmates “At a wage of $50 per hour, how many hours (between 0 and 40) would you work a week?” Continue questioning the same three students for each wage level in the chart below. Wage (per hour) Number of hours worked each week (up to 40) Number of hours worked each week (up to 40) Number of hours worked each week (up to 40) Total market supply schedule Name of Student 1 Name of Student 2 Name of Student 3 $50 30 20 10 5 2 Ask the classmates what other things they considered when deciding how many hours they would work. Record their answers here. What happens to the number of hours each student will work as the wage falls? Add the quantities of tickets hours each classmate will work at each wage level (i.e., add the numbers across the rows. Record this sum in the last column. Draw the market supply curve on the graph below. Be sure to label the axes. Handout 3-4 Date_________ Name____________________________ Class________ Professor________________ Shifts and Movements Along the Supply Curve Decide whether the following examples indicate a shift of the supply curve or a movement along the demand curve. Mark the correct column. Example Movement along the supply curve A shift in the supply curve 1. As home prices rise, more people put out a For Sale sign. 2. Personal bankruptcies rise with the recession, forcing homeowners to sell. 3. College grads avoid teaching jobs as starting salaries fall. 4. Worsening working conditions in urban schools chase away prospective teachers. 5. As the price of airline tickets rises, airlines add more flights. 6. The price of jet fuel drops and airlines expand the number of flights. Handout 3-5 Date_________ Name____________________________ Class________ Professor________________ A Ticket Shortage Imagine the following scenario: You are responsible for a concert on campus and have sold out all the tickets at $20 apiece. Unfortunately, there are 100 students outside the concert who still want to get in and are angry and frustrated. Answer the following questions: 1. Is $20 the equilibrium price? 2. How do you remedy the ticket shortage? 3. Label each of the following graphs to identify what kind of solution it represents for the ticket shortage. 4. Which solution would fans prefer? Concert organizers? Handout 3-6 Date_________ Name____________________________ Class________ Professor________________ Applying Analysis to a News Article: Supply and Demand Using an article from a newspaper, magazine, or relevant online source that is about a specific market and that indicates a change in price of the product. 1. Identify the relevant market. 2. Describe the nature of the change in the market: shift in demand or shift in supply. 3. Describe the direction of the shift. 4. Describe what induced the shift. 5. Indicate the effect of the shift on the equilibrium market price. 6. Indicate when you can predict the change in the equilibrium quantity, and indicate when you cannot. Chapter 4: Consumer and Producer Surplus What’s New in the Fifth Edition? • Updated Economics in Action examples • Updated Business Case Chapter Objectives • Define consumer surplus and its relationship to the demand curve. • Define producer surplus and its relationship to the supply curve. • Define total surplus and explain how it can be used to measure gains from trade. • Discuss two necessary features of well-functioning markets: property rights and prices as economic signals. • Explain why markets are often efficient and why they sometimes fail. Teaching Tips Consumer Surplus and the Demand Curve Creating Student Interest • Have students consider and discuss the process of buying a new car. (This also can be an opportunity to provide some instruction in real-world financial literacy.) Do most people walk into a dealership and pay the sticker price on the side of the car? Should they? Does everyone pay the same price for the same car? Why? Why not? How has the internet changed the way people buy new cars? Since buyers negotiate their own deal for differentiated new cars (including financing and trade-in), they pay different prices. What determines how much they pay? (Their willingness to pay and the amount of consumer surplus they can bargain for.) • Ask students if they have ever entered a store expecting to pay a certain price for a good (e.g., $10 for a book) and found that the book was on sale for $8. Have them imagine that it happens. Would they pay the $10, or only $8? How would they feel about paying less? • Another example is going to buy a good (e.g., toothpaste) and finding a valid coupon for the toothpaste you want sitting on the shelf next to it. Would they use the coupon, and how would they feel about it? Coupons are often left around stores (or dispensed from a machine provided by the store). Perhaps they are left by the consumer surplus fairy! Presenting the Material • Students rarely have difficulty understanding the basic concept of consumer surplus. They understand there is a difference between the amount they are willing to pay for a good and the price the store is charging. They know that when a good goes on sale they are getting a better deal, and at this point you can tell them that this savings represents consumer surplus. Move from the basic concept and definition of consumer surplus to a table like the one illustrated below. Students will generally be able to calculate individual and total surplus from the table. Point out that when the willingness to pay is less than the actual price, the person will choose not to buy the good. Before moving on to the graph, ask them what they think happens to consumer surplus when price changes. Willingness to pay for one hour of math tutoring Actual market price for one hour of math tutoring Consumer surplus Jack’s willingness to pay = $24 Price = $10 $14 Karla’s willingness to pay = $21 Price = $10 $11 Harold’s willingness to pay = $18 Price = $10 $8 Kathy’s willingness to pay = $10 Price = $10 $0 Chester’s willingness to pay = $5 Price = $10 n/a • Moving from the table to the graph can be challenging for some students. Start by plotting the price quantity points for the five people in the table on the graph. Next, draw the demand curve as a step graph. Tell them the steps exist because you are only selling five whole units to five individuals, which means you must lower the price by a significant amount each time before another buyer jumps into the market. The step graph will make the geometry of consumer surplus easier to understand. Once they have grasped the idea that consumer surplus is the area under the demand curve and above the price line, transition back to the normal demand curve. Explain that each point on the demand curve represents an amount that someone is willing to pay. Draw vertical lines from the demand curve to the price line to represent the individual consumer surplus. Producer Surplus and the Supply Curve Creating Student Interest • Ask students what determines the lowest price a seller is willing to sell a good for. Help students see that this price will be equivalent to the seller’s cost. The cost in this case represents all the opportunity costs of the seller. • Return to the new car example. Ask about the motivations of the seller—what is the seller trying to do? (Maximize their producer surplus.) What determines the lowest price the seller will take? (Their costs, including opportunity costs, and their minimum acceptable profit.) What information do they use to determine how high they can set the price of the new car? (Information about demand and the consumer’s willingness to pay.) The car dealer is trying to maximize producer surplus (and minimize consumer surplus) while the buyer is trying to do the opposite. Presenting the Material • Students often have more trouble understanding producer surplus, perhaps because they are not used to thinking of themselves as sellers of a good. Emphasize that the seller is willing to sell a good for any price that at least covers his cost of production. The greater the price compared to the cost of production, the higher the producer surplus. To present the concept of producer surplus, take the same approach used earlier to present consumer surplus. Start with the data in the table below, then progress to the step graph, and finally the regular supply curve. Make clear that we are now looking at tutors and their willingness to sell their services. The opportunity cost of using their time in tutoring is equal to the forgone value of that time in other activities. Seller’s minimum price to sell (= the seller’s opportunity cost) Actual market price for tutoring Producer surplus Jane’s price = $12 $10 n/a Dora’s price = $10 $10 $0 Lee’s price = $8 $10 $2 Sam’s price = $6 $10 $4 Kathy’s price = $4 $10 $6 The total producer surplus is the sum of the individual seller’s producer surplus. Here it is equal to $12. Again, you can change the price to show the effect on the total producer surplus. Consumer Surplus, Producer Surplus, and the Gains from Trade Creating Student Interest • Ask students to summarize the gains from trade in the used textbook market. What is the lowest price they would accept for their used economics textbook? How did they arrive at that price? (Their opportunity cost.) What is the highest price they would (or did) pay for a used economics textbook? How did they arrive at that maximum price? (The price of a new textbook.) How would students lose if there were no market for used textbooks? (They would lose consumer surplus when they had to pay a higher price and producer surplus when they weren’t able to sell their used textbook.) Ask how new editions of a textbook and the internet have affected the market for used textbooks. (Examples: new editions decrease demand for the old edition. The internet has led to online textbooks that can’t be resold and larger markets for used textbooks.) Presenting the Material • Use a standard supply and demand graph to identify consumer and producer surplus, and to identify total surplus and the gains from trade. Explain that the competitive market equilibrium maximizes total surplus, in that there is no other price that makes both buyers and sellers better off. Although the competitive market equilibrium is efficient, this does not mean it is fair or equitable. Discuss the difference between efficient and equitable using the tutor example. What if there are students who need tutoring and they cannot afford to pay the going market price? This is a good lead-in to the concept of a price ceiling in the next chapter. A Market Economy Creating Student Interest • Ask students to raise their hand if, after studying consumer and producer surplus, they think markets are efficient. Hopefully most or all will have gotten that point. Then ask them to raise their hand if they think markets are fair. Ask those who don’t raise their hand why they didn’t. Of course, many may not be willing to raise their hand for anything, but you should be able find someone who is actually skeptical of markets. Finally, ask students if they think that markets are always efficient and the best way to allocate resources. Hopefully the students will mention monopolies, externalities, and individual versus aggregate welfare (though likely not using those specific terms). Use the discussion to lead into your presentation of market failures. • Ask students who owns the air we breathe and the fish in the sea. Have them come up with other examples of markets where property rights aren’t well defined. Presenting the Material • Emphasize that there are two main points in this chapter: (1) Markets, when they have certain characteristics, are efficient. (2) Markets sometimes fail (i.e., sometimes they do not have those certain characteristics). • Discuss the importance of property rights by getting students to think about what happens when property rights do not exist, or are not well defined. What happens, for example, if after you buy a good you do not have the right to resell it? Many mutually beneficial transactions would be prevented. Now discuss the importance of price as an economic signal. The market price of a used textbook allows sellers to determine if they are willing to sell, and it allows buyers to determine if they are willing to buy. Total surplus is therefore maximized. You may at this point introduce some of the different cases where market failure exists, depending on what you plan to cover later in the course. If, for example, you do not plan to cover all of the different cases of market failure mentioned at the end of the chapter, you might briefly mention them here as important examples that you will not have time to discuss. Common Student Pitfalls • The area of a triangle. Students may have forgotten how to calculate the area of a triangle. Review the formula ½(base)(height) or (bh/2). • Calculating consumer surplus. Students usually can understand consumer surplus for an individual unit or person, but have difficulty moving to total consumer surplus. Be sure to show how adding up all the discrete units and moving to continuous units gives us the consumer surplus triangle. Make sure students understand that consumer surplus is measured in dollars and shows how much consumers were willing to pay for the equilibrium quantity, but didn’t have to. Gaining consumer surplus adds to consumer welfare—it gives consumers a warm fuzzy feeling to get a good for less than they would have paid for it! • Calculating producer surplus. Students can have the same problems understanding producer surplus as they had with consumer surplus. However, the process of learning consumer surplus can make understanding producer surplus easier. Emphasize that these are parallel ideas. In addition, students may be unclear about the “cost” of a used textbook they plan to sell. Explain that the true cost is their opportunity cost: They are giving up the ability to use the textbook for other purposes, such as a reference for upper-division microeconomics. • The relationship between efficiency and the gains from trade. Review the meaning of efficiency: Once a market has produced its gains from trade, there is typically no way to make anyone better off without making someone else worse off. Emphasize that competitive market equilibrium achieves the maximum total surplus, but this does not mean that it is the best outcome for every buyer and seller in the market. Chapter Outline Opening Example: The used textbook market is discussed to illustrate the concepts of consumer and producer surplus. This example then appears throughout the chapter. I. Consumer Surplus and the Demand Curve A. Willingness to pay and consumer surplus 1. The total consumer surplus generated by purchases of a good at a given price is equal to the area under the demand curve but above the price. This is illustrated in text Figure 4-3, shown next. B. How changing prices affect consumer surplus 1. When the price of a good falls, the total consumer surplus increases through two channels: a gain to consumers who would have bought at the original price, and a gain to consumers who are persuaded to buy at the lower price. When the price of a good increases, the total consumer surplus decreases in a similar fashion. II. Producer Surplus and the Supply Curve A. Cost and producer surplus 1. The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price. This is illustrated in text Figure 4-8, shown next. B. Changes in producer surplus 1. If the price of a good rises, producers will experience an increase in producer surplus through two channels: the gains of those who would have supplied the good even at the original, lower price and the gains of those who are induced to supply the good at the higher price. A fall in the price similarly leads to a fall in the producer surplus. III. Consumer surplus, producer surplus, and the gains from trade A. The gains from trade 1. Both consumers and producers gain in a specific market—there are gains from trade. This is why everyone is better off participating in a market economy than they would be if each individual tried to be self-sufficient. This is illustrated in text Figure 4-11, shown here. B. The efficiency of markets: A preliminary view 1. Markets are usually efficient. Typically, there is no way to make anyone better off without making someone else worse off. 2. The market equilibrium achieves the maximum possible total surplus. It does this because the market a. allocates the good to potential buyers who value it the most, indicated by the willingness to pay. b. allocates sales to the potential sellers who value the right to sell the good the most, as indicated by the fact that they have the lowest cost. c. ensures that every consumer who makes a purchase has a value of the good greater than every seller who makes a sale, so that all transactions are mutually beneficial. d. ensures that every potential buyer who doesn’t make a purchase has a value of the good lower than that of every potential seller who doesn’t make a sale, so that no mutually beneficial transactions are missed. C. Three caveats 1. Although a market is efficient, it isn’t necessarily fair. 2. Markets can sometimes fail. 3. Even when a market maximizes total surplus, it is not necessarily best for every individual producer and consumer. IV. A Market Economy A. An economy is made up of many interrelated markets B. Why markets typically work so well 1. Prices are economic signals. C. A few words of caution 1. Markets can be inefficient. 2. Market failure occurs when a market fails to be efficient. Case Studies in the Text Economics in Action When Money Isn’t Enough—This EIA uses the right to buy a good (with a ration coupon during World War II) to explain consumer surplus. Ask students the following questions: 1. How did the use of ration coupons during WWII lead to an increase in the ultimate price of the rationed goods? (Buyers without a coupon had to pay for the coupon in addition to paying for the good itself.) 2. How could a vegetarian with a meat ration stamp gain surplus from the stamp even though she doesn’t eat meat? (She could sell her ration coupon for the meat she wouldn’t have eaten anyway, and receive surplus.) High Times Down on the Farm—This EIA discusses the rising price of farmland in Iowa and explains how rising crop prices will increase producer surplus, and therefore drive up the price of land. Ask students the following questions: 1. What are the three causes of the increase in the price of Iowa farm products? (The increase in the production of ethanol to blend into gasoline, the increase in the demand for farm products by countries like China, bad weather in Australia and the Ukraine.) 2. How does an increase in the price of farm products affect producer surplus? (It will increase.) Take the Keys, Please—This EIA discusses websites such as Airbnb, which provides a way for visitors to find a room to rent temporarily, or rather it provides a place to help buyers and sellers find one another. Ask students the following questions: 1. How does Airbnb lead to an increase in total surplus? (It allows apartment owners to rent their apartment to other people during times they are not using the residence, leading to an increase in consumer and producer surplus.) A Great Leap—Backward—This EIA considers the inefficiency of command economies using the example of China’s “Great Leap Forward.” Ask students the following questions: 1. How are consumption and production decisions made in market economies? How are they made in planned economies? (In market economies, based on price signals; in planned economies, based on the decisions of a central planner.) 2. Why do you think the plan instituted in China in the late 1950s did not lead to an efficient allocation of production and consumption? (It was based on the goals of the central planners, not the goals of producers and consumers.) For Inquiring Minds A Matter of Life and Death—This FIM presents the allocation of transplant kidneys based on “net benefit” and explains how the approach is similar to a competitive market allocation based on consumer surplus. Business Case Ticket Prices and Music’s Reigning Couple, Jay-Z and Beyoncé—This business case explains why Jay-Z and Beyoncé priced their tickets at a low or accessible price on their recent “On the Run” tour, and then goes on to discuss how internet sites like StubHub can buy the low-price tickets and resell them at much higher prices, thereby capturing some of the producer surplus forfeited by the musicians. Activity Understanding Property Rights (15–25 minutes) Use something to represent a good—for example, paper clips or small plastic fish (if you want to represent a real-world common property resource). You also can do this with pennies or nickels, if you are willing to provide them! Spread the paper clips out on the floor or a desk. Ask for five student volunteers to assume the roles of paper clip harvesting companies. Tell them that they are profit-maximizing companies. Their goal is to be the student that earns the most money from harvesting paper clips. Their grade for the day will be based on how well they achieve this goal. Make sure they know that they want to harvest and sell the most paper clips. (You may want to give the incentive of “bonus points” to the student who harvests the most.) This exercise sets up a “tragedy of the commons” scenario. Tell them that there will be two harvests, each lasting 30 seconds. For any paper clips they harvest from the first period, you will pay them one fictitious dollar. For any paper clip they harvest from the second period, you will pay them two fictitious dollars. Then tell them “go” and time the first harvest. While they may start out tentative, eventually they (or at least one of them) will grab all of the paper clips. End the first period and have them count their harvest. Repeat the procedure for the second harvest, even though there are probably no paper clips left. Tally their total revenue for the two periods and calculate the combined total revenue of the five firms. Ask students why they behaved the way they did. If they didn’t maximize by harvesting all the paper clips in the first round, emphasize their goal, ask them questions to help them see their best strategy, and try again. However, generally at least one student will understand and try to harvest before everyone else. Now, take back the paper clips and put them back on the floor/table. Take some masking tape and mark an X within the paper clip distribution—that is, dividing the paper-clip area into quadrants. Make sure no paper clips are on the tape—all paper clips should be within one of the quadrants defined by the masking tape X. Give each student property rights to one of the sections (four students get a section that contains paper clips and one student gets everywhere else—which has no paper clips). No one is allowed to touch anyone else’s paper clips. Now repeat the exercise. Students will save all (or at least some) of the paper clips for the second round. The total revenue for the firms combined will be higher as property rights allow the students to delay the harvest to the second, more lucrative period. Ask students about their behavior—and be sure to get the views of the student who didn’t “own” any paper clips. Why did they do what they did? When did they earn more—with or without property rights? (With, if the students tried to achieve the stated goal of getting the most paper clips.) What did the higher price in the second round represent? (The benefit of not depleting the resource—such as allowing fish to remain to regenerate.) Was everyone better off with property rights? (Not the student without any!) Will assigning property rights always be the way to achieve efficiency? (Not when you can’t assign them—e.g., you can’t fence in ocean fish, or brand them, or make them wear collars!) However, property rights can lead to efficiency in many situations. Web Resources The following website presents 10 steps to buying a new car. You can use this website to discuss the new-car buying process and ways to increase consumer surplus when buying a new car. https://www.edmunds.com/car-buying/10-steps-to-buying-a-new-car.html The web address for Airbnb is: https://www.airbnb.com/ Handout 4-1 Date_________ Name____________________________ Class________ Professor________________ What’s Your Bid? Ask five classmates what they would be willing to pay for a Biology textbook for a class they will take next semester. Record these amounts in the table below. Classmate’s name Willingness to pay Consumer surplus Total surplus Calculate each classmate’s consumer surplus if the used price of the textbook is $35. Then, calculate the total consumer surplus. What’s a New Drug Worth? (3–5 minutes) Given the idea of consumer surplus, how would you go about assigning a monetary value to the benefit of a new drug on the market that cures autoimmune diseases? Handout 4-2 Date_________ Name____________________________ Class________ Professor________________ What’s Your Minimum Offer Price? Ask five classmates what they would be willing to accept to sell their Econ textbook at the end of the semester. Record these amounts in the table below. Classmate’s name Willingness to pay Consumer surplus Total surplus Calculate each classmate’s producer surplus if the buyback price of the textbook is $25 at the campus bookstore. Then, calculate the total consumer surplus. What’s an Internship Worth? You have the opportunity to do a summer internship abroad for 3 months for a fixed salary of $800 per month, but the costs of rent, food, and travel expenses are not included. What is your producer surplus? Instructor Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780
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